Is There A Neutral Interest Rate? If So, How Much Is it?

"The Fed held its benchmark federal-funds rate steady at the May meeting
in a range between 1.5% and 1.75%, but it looked ahead to future
increases that might leave policy at a neutral level that neither spurs
nor slows growth."

"The Fed’s postmeeting statement at the May meeting caught some attention
because officials added a second reference to their “symmetric” 2%
inflation target, meaning they won’t necessarily accelerate interest
rate increases once inflation runs at or slightly above 2%."

Some officials at the May meeting said a temporary period in which
inflation rises modestly above 2% “would be consistent with the
committee’s symmetric inflation objective and could be helpful in
anchoring longer-run inflation expectations at a level consistent with
that objective.”

At the time of the May meeting, the unemployment
rate had held steady since October at 4.1%. A report released after the
meeting showed the rate fell to 3.9% in April.

Most
officials still believe in a framework that sees an inverse
relationship between unemployment and inflation (the is is the Phillips Curve). If the unemployment
rate drops faster, officials likely will be more attuned to the
potential for acceleration in inflation.

The minutes show
officials are still unsure over the degree to which lower unemployment
will fuel faster wage increases or firmer price pressures"

"San Francisco Fed President
John Williams
said last week he still estimates the current neutral fed-funds
rate to be 2.5%. Officials’ March projections show a median expectation
that the fed-funds rate would settle over the long-run at around 2.9%—an
approximation of neutral.

Estimates of the neutral rate matter
because a consensus appears to be forming among Fed officials that they
should stay on their current “gradual” path of raising rates by a
quarter percentage point at roughly every other meeting until they reach
neutral. The bigger debate is likely to be over what to do after they
get there."

AD and SRAS help explain what is going on. As AD increases or shifts to
the right, prices rise. But the increases get bigger. Q or GDP
increases, which lowers unemployment, but less each time. That tells the
same story as the Phillips curve. But, what if supply shifts to the
right? (which I don't show). If SRAS shifts more to the right than AD,
then the rise in prices might be slight (and inflation could be less
than what it was in the past) while the increases in Q can be large and
the unemployment rate falls. That is the opposite of the Phillips Curve.
So the Phillips Curve has to assume a fixed SRAS. Maybe a neutral interest rate keeps AD right at QF, the level of GDP that gives us the lowest rate of unemployment with inflation no higher than a set target. This is full-employment.